We update the performance--and make one small adjustment--to our middle-of-the-road portfolio.
By Christine Benz | 02-20-14 | 06:00 AM | Email Article

Bucket 1: Years 1-2

Original Portfolio

  • $100,000: Cash (certificates of deposit, money market funds, and so on)

Adjustments: None

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

The goal of this portion of the portfolio is to lock down money needed for near-term living expenses; income production is secondary.

Therefore, it holds true cash instruments rather than venturing into investments such as ultrashort funds, which may at times deliver higher yields but do so at the expense of principal volatility.

As I argued in this article, investors are simply not being rewarded for investing in these cash substitutes at this time. 

Bucket 2: Years 3-12

Original Portfolio

Adjustments: Use Vanguard Short-Term Inflation-Protected Securities Index (or Vanguard Short-Term Inflation-Protected Securities Index ETF ), instead of Harbor Real Return.

Bucket 2 is designed to deliver a higher level of income than bucket 1; it also aims to preserve purchasing power with a dash of capital appreciation. The risk level in this portfolio stairsteps gradually upward. The T. Rowe Price fund would serve as next-line reserves in case bucket 1 were to become depleted and rebalancing proceeds and/or portfolio income were insufficient to meet living expenses. I've also included a slice of a floating-rate, or bank-loan, fund. This Fidelity fund, while potentially sensitive to the credit cycle, should hold its ground and even gain in a period of rising interest rates. Harbor Bond, a near-clone of  PIMCO Total Return , remains the portfolio's largest bond holding; I like the flexibility afforded by its core-plus mandate, which Morningstar's Eric Jacobson discusses in this video

As with the aggressive portfolio, however, I'd swap out Harbor Real Return, an inflation-protected bond fund, in favor of Vanguard's new short-term Treasury Inflation-Protected Securities fund. Although each fund invests in bonds whose principal values increase to keep pace with inflation, the Vanguard short-term fund delivers inflation protection without a lot of interest-rate-related volatility. Investors could also use individual I-bonds in this slot, too. 

A position in Vanguard Wellesley Income, which features a roughly 60% bond/40% stock allocation, is the longest-term component of the portfolio, providing both income and a shot of capital appreciation. 

Bucket 3: Years 13-20

Original Portfolio

Adjustments: None. 

The long-term portion of the portfolio, geared toward growth, remains unchanged and generally mirrors bucket 3 of the aggressive portfolio. It includes a high-quality equity emphasis with its position in Vanguard Dividend Growth, but it also features broad-ranging sector exposure owing to the total market U.S. index fund. I'm hanging on to the position in Harbor International despite the impending departure of one of its comanagers; its remaining managers are experienced and employ a disciplined process. I also continue to like Loomis Sayles Bond for the long term. Although I've been concerned about investors' stampede into aggressive, credit-sensitive bond types, Loomis' flexibility to invest in foreign bonds, convertibles, and even stocks is an advantage. Just be sure to hold any such fund among your longest-term assets rather than in bucket 2. 

Keeping the position in Harbor Commodity Real Return, in place to provide some inflation protection, is more controversial. Not only have commodities prices slumped as a result of slack demand from emerging markets, but this fund's bond portfolio has also proved quite interest-rate-sensitive because it emphasizes TIPS. I'm retaining the position because our anticipated holding period for it is quite long--10-plus years--offering enough time to ride out interest-rate-related volatility and provide our desired hedge against inflation. 

Although the portfolio isn't designed to shoot out the lights during any short-term time period, it outperformed its custom benchmark by a tiny margin since it originally appeared in October 2012. The portfolio returned 10.5% from Oct. 25, 2012, through Feb. 14, 2014, whereas a basket of index funds mirroring its starting asset allocation (23% domestic stock, 12% foreign stock, 49% bonds, 5% commodities, and 11% cash) returned 10.3%. (Those figures include reinvested income, dividends, and capital gain distributions, but they do not include any portfolio withdrawals.) The bond portfolio's fairly short duration and stake in noncore bond assets such as Loomis Sayles Bond was a help; the position in Harbor International also beat a broad-market foreign-stock index fund.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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